If you were asked: would you rather have a million dollars today or a penny that doubles every day for thirty days, what would you choose? Many would simply take the million dollars. However, for those that understand the power of compounding interest, their answer might differ. The penny that doubles every day for thirty days would actually equal over five million dollars at the end of thirty days. Compounding interest can increase the value of an investment exponentially when interest is earned on both the money you have saved and the previously accumulated interest. Doubling your money every day is not a realistic assumption for investing, but extreme examples such as this illustrate the power of compounding. Compounding interest is a fascinating part of investing that every investor should both understand and incorporate into investment planning.
The power of compounding interest is why investing early is beneficial.
You have probably heard many financial experts say that the earlier you can start saving for retirement, college, or any other long-term goal, the better. This is due to compounding interest. By investing early, your portfolio benefits from the value of time and compounding. If we added just one more day to the graph above in the example with the penny doubling every day, we would have $10,737,418.24 in 31 days. But as you can see, much of the price appreciation comes in the final ten days. I point this out so that investors do not get discouraged early on. As mentioned, doubling your money every day is unlikely, but long-term growth over time is why we invest. It takes time to build wealth and to allow your money work for you. This is also why we recommend that as investors age, they should consider becoming more conservative with their portfolio risk. A dramatic decrease in your portfolio value can really set you back with little time to recover.
The rule of 72 helps you understand compounding interest.
The power of compounding can be beautiful when it works in your favor. The markets have never operated in the example with the penny doubling every day, however by using average annual return you can estimate the potential value of your portfolio 10, 20, and 30 years in the future.
If you are interested in estimating the approximate time it takes for your portfolio to double assuming a constant annual rate of return, you can use the rule of 72. The time it takes your portfolio to double approximately equals 72/r where r is net rate of return. For example, if your portfolio returned 7.2% each year it would double in roughly ten years, 72/7.2 = 10 years. The rate of return on your investments is based on many factors, including your investment allocation and risk tolerance.
Compounding interest isn’t the end-all, be-all.
While the idea of putting money into the market and just letting it grow is a valuable thought exercise, most people should not rely solely on their initial investment. Instead, you should be contributing to your investments when financially feasible. I previously wrote about the benefits of dollar cost averaging. The basic strategy of DCA investments is the opposite of making a lump sum investment all at once, and instead spreading out investments over time. I believe combining this strategy with the understanding of compounding interest is a recipe for success but is never a guarantee.
As part of our financial planning at Marshall Financial Group, we consider your investments, goals, and data to develop a financial strategy we believe will work for you. If you have any questions, don’t hesitate to contact us.
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